Valuation is implying only 70% of estimated growth in earnings; energy ROCE likely to be 15% by FY19e, making stock an outperformer
What’s next: This was the key investor question in the past two weeks after RIL’s 17% outperformance versus Sensex. While investor debate on telecom earnings and energy project execution may continue near term, we believe delivery of energy earnings will provide the next leg of stock performance, as it should boost earnings expectations and lift returns. Telecom’s drag on returns may reduce at the margin but is unlikely to halt overall growth in returns, as energy investments deliver on earnings growth steadily until FY20.
Interestingly, there was limited pushback to our telecom business valuation of 0.6x EV/IC.Most investors remain skeptical on timely project execution, as RIL had seen challenges in the past; we assume a 3-6 month delay as part of our base case, but medium-term commissioning of energy projects should help reduce concerns, in our view.
How is RIL benefiting from energy tail-winds?
As outlined in our earlier report, ‘The Fantastic Four’ trends underpin our increased confidence in RIL’s energy and chemicals business. RIL is one of the few global energy majors that benefits from Asian gas glut, China’s supply-side reforms in chemicals, slowing oil oversupply and rising US gas prices. We expect this to drive 13% CAGR earnings growth over 2017-19. Since the completion of its energy/ chemical projects, RIL’s vertical integration in the energy value chain has deepened, increasing its flexibility to take advantage of changing energy prices while lowering earnings volatility—a key differentiator versus global peers, in our view.For example, oil prices have declined by 10% YTD, but the impact on RIL we estimate is negated by lower ethane costs, which have declined in-line with oil prices and lower Asian gas prices (LNG) that have underperformed oil by 20% YTD.
Can RIL grow returns?
After five years of stock underperformance and return ratios that have also trailed peers’ by 500 bps, we think investor skepticism about our positive thesis on RIL is understandable. However, our conviction that the stock will outperform stems from our positive view on energy ROCE, which we believe is set to rise 500 bps by FY19e
When will FCF start to rise? Can it drive stock performance?
We expect capital intensity to halve from H2FY18, moving RIL into positive FCF mode, despite high telecom capex. RIL’s dividend payout in the past 10 years has been at 15% of net profits, well below global peers’ average of 47%. Despite this, the stock has typically outperformed the local index by an average ~24% on the 12 occasions since 1994 when FCF has risen.
Are valuations full for the stock?
We believe that RIL stock is implying only 70% of our estimated growth in energy earnings, assuming our base case telecom valuations. The stock trades at 7x EV/Ebitda on FY19e earnings i.e. 12% discount to regional peers, while on P/E basis it trades at 12xF19e earnings, a 10% discount to its 10-year average.
Why do we value telecom at 0.6x EV/IC?
Reliance Industries’ telecom business is transitioning from a capex to a subscriber acquisitions phase. The company’s focus is on retaining & growing subscribers, as well starting revenue generation to recover its capital employed. Our target multiple is based on valuing Jio’s FY21e Ebitda at an EV/Ebitda multiple of 6.0x and discounting it back using a discount rate of 12%.